02 March 2019

Japanese stock market continued to edge higher last week, as usual taking its cue from US shares which have retained their upward trend. Topix closed the week above its 100-day moving average for the first time since October of last year and looks poised to move higher in our opinion. However, we have clearly come to a point where market participants have become more nervous about weak economic data and poor immediate earnings outlook which have made the easy share price gains of this year more difficult to replicate. Nevertheless, we see certain segments of the market looking extremely attractive as we foresee strong evidence emerging over the next month or two, pointing to better fundamentals ahead, namely for semiconductor and factory automation plays which remain among our top buy calls in Japan.

With geopolitics continuing to dominate the market mood, we remain highly focused on developments there. As we have underlined from late last year, we feel some sort of US trade deal with China is now certain as neither side can now afford to walk away. Although the congressional testimony of the US trade representative and a notable China hawk, Robert Lighthizer did briefly worry markets again about a prospect of a no deal, clearly Trump is ready to sign a trade agreement with China which has shown strong resolve to tackle more difficult aspects of what the Americans have been demanding including China's policies on currency intervention, intellectual property rights, and even the state sponsorship of its technology champions.

We believe the potential lifting of uncertainties regarding trade is far more potent than many believe as resumption of capital investments in China in factories and data centres alone will have a very positive knock-on effects on key related businesses in US and Japan. Moreover, the more recent economic data from China seems to underline that the downturn in consumption there is starting to moderate as the economy is starting to respond to stimulus. Certainly, MSCI's latest move in raising China's global weighting will no doubt further help sentiment there.

With the US Federal Reserve also adopting a far more dovish monetary policy stance than last year, de-emphasising its concerns about inflationary expectations from the tight US labour market, and its board members now openly discussing the wisdom of applying the Phillips Curve model in today's economy, we think fighting the Fed by being bearish on stocks will prove futile. The US central bank is going as far as reversing its "auto-pilot" position in regards to shrinking of its $4trn balance sheet to more a normalised historical levels, with unveiling of the expected deadline for halting the runoff likely to add more fuel to stock market's rally.

However, geopolitical uncertainties remain and this week we like to underline some major obstacles ahead which could dampen sentiment and which the markets could find challenging. Needless to say, the recent skirmishes between India and Pakistan is a worrying development to keep an eye on given that these two nuclear powers are clearly posturing to go to war. This outcome in our view is unlikely but could make emerging markets highly nervous in the shorter term. Although the Brexit issue is another lingering concern, we think a 'no-deal' Brexit is also an unlikely prospect despite the ongoing threat of such an outcome as we believe calmer heads will eventually prevail and the political paralysis that has gripped Britain since 2016 will eventually be untangled.

More worrying in our view is the US auto-related trade issues with EU, Japan and Korea as we are awaiting the unveiling of an investigation findings of whether imports of cars and car parts pose a threat to US national security. We think the findings will most likely show that they do and Mr. Trump will use his old playbook and impose at least 10% tariffs on such imports with a threat to raise them higher and use that as leverage to get more concessions from the coming bilateral trade negotiations. We think this makes Japan's auto sector vulnerable to some immediate bad news ahead, before the US/Japan trade talks which was supposed to begin sometime this month.

Another obvious concern is the potential for a major political upheaval in the US as Michael Cohen's recent congressional testimony clearly underlined that ongoing investigation of Robert Mueller seems to have gathered substantial evidence against the US president and his inner circle and the findings will most likely be publicly unveiled as has been demanded by the House of Representatives, now majority led by Democrats. This could make the US president's future actions and policies much more erratic and unpredictable as we get closer to the final report from the Special Counsel which has been given until the end of June to further conduct its investigation.

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